FORM 10-K

(Mark One)

Commission file number 0-49663

SUN HEALTHCARE GROUP, INC.
(Exact name of registrant as specified in its charter)

18831 Von Karman, Suite 400
Irvine, CA 92612
(949) 255-7100
(Address and telephone number of Registrant)

Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Title of each class
Common Stock, par value $.01 per share
Warrants to purchase Common Stock, $.01 par value per share

     Indicate by check mark whether the registrant (1) has filed all reports required by Section 13(a) or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past ninety days. Yes [X]     No [  ]

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in the definitive proxy statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [   ]

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes [X]     No [ ]

   The aggregate market value of the Registrant's Common Stock held by nonaffiliates, based on the last sales price of such shares on the Nasdaq National Market on June 30, 2004, was approximately $135.3 million.

     Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12 or 13(a) or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes  [X]  No  [  ]

     On March 1, 2005, Sun Healthcare Group, Inc. had 15,326,176 outstanding shares of Common Stock.

     Documents Incorporated by Reference: None

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___________________

     References throughout this document to the Company, "we," "our," "ours" and "us" refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

     SunBridge®, SunDance®, SunPlus®, CareerStaff Unlimited® and related names are registered trademarks of Sun Healthcare Group, Inc. and its subsidiaries.

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PART I

     General. We are a nationwide provider of long-term, subacute and related specialty healthcare services in the United States. We currently operate through various direct and indirect subsidiaries that engage in the following five principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, (iii) medical staffing services, (iv) home health services and (v) laboratory and radiology services.  The following is a description of our current business segments and divested operations. Financial information for each of the business segments is set forth in "Note 18 - Segment Information" in our consolidated financial statements.

     Inpatient Services. As of March 1, 2005, we operated 104 long-term care facilities (consisting of 87 skilled nursing facilities, eight assisted living facilities, six mental health facilities and three specialty acute care hospitals) in 13 states with 10,659 licensed beds through SunBridge Healthcare Corporation and other subsidiaries (collectively, "SunBridge"). Our long-term and subacute care facilities provide inpatient skilled nursing and custodial services as well as rehabilitative, restorative and transitional medical services. We provide 24-hour nursing care in these facilities by registered nurses, licensed practical nurses and certified nursing aides. Our specialty acute rehabilitation hospitals provide a range of inpatient and outpatient services for people with traumatic brain injuries, strokes, arthritis, and other disabling conditions. Our assisted living facilities serve the elderly who do not need the level of nursing care provided by long- term or subacute care facilities, but who do need some assistance with the activities of daily living.

     Rehabilitation Therapy Services. We provide rehabilitation therapy services through SunDance Rehabilitation Corporation ("SunDance"). SunDance provides a broad array of rehabilitation therapy services, including speech pathology, physical therapy and occupational therapy. As of March 1, 2005, SunDance provided rehabilitation therapy services to 403 facilities in 40 states, 313 of which were operated by nonaffiliated parties. We also provide rehabilitative and special education services to pediatric clients as well as rehabilitation therapy services for adult home healthcare clients in the greater New York City metropolitan area through HTA of New York, Inc., a wholly-owned subsidiary.

     Medical Staffing Services. We are a nationwide provider of temporary medical staffing through CareerStaff Unlimited, Inc. ("CareerStaff"). As of March 1, 2005, CareerStaff derived approximately 20.0% of its revenues from schools and governmental agencies, 54.5% from hospitals and other providers and 25.5% from skilled nursing facilities. CareerStaff provides (i) licensed therapists skilled in the areas of physical, occupational and speech therapy, (ii) nurses, (iii) pharmacists, pharmacist technicians and medical imaging technicians and (iv) related medical personnel. As of March 1, 2005, CareerStaff provided medical staffing services in major metropolitan areas in 16 states, and also placed temporary traveling therapists in smaller cities and rural areas.

     Home Health Services. As of March 1, 2005, we provided skilled nursing care, rehabilitation therapy and home infusion services to adult and pediatric patients in California and Ohio through SunPlus Home Health Services, Inc. ("SunPlus"). SunPlus also operates two licensed home infusion pharmacies in California.

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     Laboratory and Radiology Services. Through SunAlliance Healthcare Services, Inc. ("SunAlliance"), we provide mobile radiology services to skilled nursing facilities in Arizona, Colorado and Massachusetts and medical laboratory services to skilled nursing facilities in Massachusetts.

Current Liquidity.    For the year ended December 31, 2004, our net loss was $18.6 million and our net cash decrease was $3.0 million. As of December 31, 2004, our working capital deficit was $30.6 million. We had cash and cash equivalents of approximately $22.6 million, a $0.6 million outstanding balance under our revolving senior loan agreement, and approximately $25.8 million of funds available for borrowing under our revolving senior loan agreement. Our working capital deficit and cash position were significantly improved by the receipt of $52.3 million of proceeds realized from the private equity placement of our common stock and warrants to purchase common stock to investors in February 2004. We believe that our existing cash reserves, the proceeds of up to $15.0 million due to us in 2005 from the sale of our SunScript pharmacy operations in 2003, and availability for borrowing under our loan agreement will provide sufficient funds for our operations, capital expenditures and regularly scheduled debt service payments at least through the next twelve months.

Restructuring. During the period of January 1, 2003 through December 31, 2004, we divested 133 inpatient facilities and had identified an additional three facilities that we intend to transition to new operators. During that restructuring of our facility portfolio, we withheld certain rent and mortgage payments from our landlords and mortgagors. As of December 31, 2004, $1.9 million of the unpaid rent and mortgages related to divested buildings remains in other accrued liabilities.

     On October 14, 1999, we commenced chapter 11 bankruptcy proceedings. On February 6, 2002, the Bankruptcy Court approved our Plan of Reorganization that was filed with the Bankruptcy Court on November 7, 2001. On February 28, 2002, we emerged from proceedings under the Bankruptcy Code pursuant to the terms of our Plan of Reorganization. (See "Note 1 - Nature of Business - Reorganization" in our consolidated financial statements.)

     Our business is competitive. The nature of competition within the inpatient services industry varies by location. We compete with other facilities based on key competitive factors such as our reputation for the quality and comprehensiveness of care provided; the commitment and expertise of our staff; the innovativeness of our treatment programs; local physician and hospital support; marketing programs; charges for services; and the physical appearance, location and condition of our facilities. The range of specialized services, together with the price charged for services, are also competitive factors in attracting patients from large referral sources.

     We also compete with other companies in providing rehabilitation therapy services, medical staffing services, home health services, and other ancillary services, and in employing and retaining qualified nurses, therapists and other medical personnel. The primary competitive factors for the ancillary services markets are quality of services, charges for services and responsiveness to customer needs.

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     As of March 1, 2005, we had approximately 15,800 full-time and part-time employees. Of this total, there were 10,400 employees in our long-term and subacute care operations, 2,300 employees in the rehabilitation therapy services operations, 1,300 employees in the medical staffing business, 1,200 employees in the home health business, 300 employees in the laboratory and radiology business, and 300 employees at the corporate and regional offices. As we divest inpatient facilities pursuant to our restructuring initiative, the number of employees in our long-term and subacute care operations will decrease accordingly.

     We operate 14 buildings with union employees. Approximately 914 of our employees (5.8% of our employees) who work in long-term care facilities in Alabama, California, Georgia, Massachusetts, Ohio, Tennessee and West Virginia are covered by collective bargaining contracts. Collective bargaining agreements covering 498 of these employees (3.2% of our employees) will expire in 2005 and will be subject to renegotiation with the unions.

     Revenue Sources. We receive revenues from Medicare, Medicaid, private insurance, self-pay residents, other third party payors and long-term care facilities that utilize our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our facilities, the acuity level of patients and the rates of reimbursement among payors. The following table sets forth the total revenues and percentage of revenues by payor source for our continuing operations, on a consolidated and on an inpatient operations only basis, for the years indicated (in thousands):

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	(1)	Includes revenues for discontinued operations for the two months ended February 28, 2002.
	(2)	Includes revenues from the provision of rehabilitation therapy and medical staffing services to nonaffiliated long-term and subacute facilities and not directly charged to Medicaid or Medicare. Nonaffiliated sources may themselves derive all or a portion of their revenues from Medicaid and/or Medicare.

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     Medicare. Medicare is available to nearly every United States citizen 65 years of age and older. It is a broad program of health insurance designed to help the nation's elderly meet hospital, hospice, home health and other health care costs. Health insurance coverage extends to certain persons under age 65 who qualify as disabled and those having end-stage renal disease. Medicare includes four related health insurance programs: (i) inpatient hospital, skilled long-term care, home healthcare and certain other types of healthcare services ("Part A"); (ii) physicians' services, outpatient services and certain items and services provided by medical suppliers ("Part B"); (iii) a managed care option for beneficiaries who are entitled to Part A and enrolled in Part B ("Medicare Advantage" or "Medicare Part C"); and (iv) a new Medicare Part D benefit that becomes effective in 2006 covering prescription drugs. The Medicare program is currently administered by f iscal intermediaries (for Part A and some Part B services) and carriers (for Part B) under the direction of the Centers for Medicare and Medicaid Services ("CMS") (formerly the Health Care Finance Administration), a division of the Department of Health and Human Services ("HHS").

     The following table sets forth the average amounts of Medicare Part A revenues per patient, per day, recorded by our skilled nursing ("SNF") and hospital facilities for the years ended December 31:

     Medicare reimburses our skilled nursing facilities under a prospective payment system ("PPS") for inpatient Medicare Part A covered services. PPS was adopted pursuant to the Balanced Budget Act of 1997 (the "1997 Act"). Under PPS, facilities are paid a predetermined amount per patient, per day, based on the anticipated costs of treating patients. The amount to be paid is determined by classifying each patient into one of 44 resource utilization group ("RUG") categories that are based upon each patient's acuity level.

     The nursing home industry came under financial pressure as a result of the implementation of PPS and other 1997 Act provisions.  As a result, in fiscal years 1999 and 2000 Congress implemented add-on payments to restore substantial Medicare funding to skilled nursing facilities and other healthcare providers that was originally eliminated by the 1997 Act. Two of those add-ons remain in place today: a 6.7% increase for patients requiring intense rehabilitation and a 20.0% increase for patients requiring complex medical care. These two add-ons are scheduled to expire when CMS releases refinements to the current RUG payment system. On July 30, 2004, CMS announced that the current RUG payment system would remain in place for the 2005 fiscal year (October 1, 2004 - September 30, 2005) thus leaving the current classification system and add-ons in place for fiscal year 2005. On February 8, 2005, President Bush presented his budget proposal for feder al fiscal year 2006 (October 1, 2005 - September 30, 2006). The budget proposal includes a $1.5 billion reduction to Skilled Nursing Facility funding caused by refining the RUG payment system. We are unable to determine when, or if, President Bush's proposed reduction in reimbursements would become effective. Should the President's proposed reduction become effective, our per diems and our pretax income could decrease by approximately $10.3 million in 2006 ($25.03 per Medicare patient day.) For the three and twelve months ended December 31, 2004, we generated approximately $2.6 million and $10.2 million, respectively, in revenues and pretax income as a result of existing add-ons.

     CMS issued two increases in nursing facility rates effective October 1, 2003: a 3.0% increase of the annual update to the market basket and an additional 3.3% market basket increase to correct the

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underestimate of the market basket forecast in prior years. We estimate our Medicare revenues increased approximately $6.1 million ($19.75 per Medicare patient day) for the nine months ended September 30, 2004, as a result of the combined increases. In addition to the 2004 increases, CMS increased the market basket 2.8% effective with the 2005 Federal fiscal year beginning October 1, 2004, which when taken into consideration with the Federal wage index adjustments is a 3.0% increase. We estimate our Medicare revenues increased approximately $1.0 million ($9.65 per Medicare patient day) for the three months ending December 31, 2004 as a result of the market basket increase and the Federal wage adjustment.

     Medicare Part B payments are generally adjusted annually, effective upon the calendar year beginning January 1 and ending December 31. The Medicare Prescription Drug, Improvement and Modernization Act of 2003 authorized a 1.5% increase for calendar year 2004, which we estimate resulted in increased rehabilitation therapy revenues for the three and twelve months ended December 31, 2004 of $0.1 million and $0.6 million, respectively. On November 15, 2004, CMS published final payment rates for calendar year 2005 that will result in a 1.5% rate reduction to rehabilitation therapy services. We estimate that our annual revenues will decrease $0.7 million for the year ended December 31, 2005.

     Our home health Medicare payment rates increased 3.3% during the period of October 1, 2003 to December 31, 2004, which we estimate increased our Medicare revenues for the three and twelve months ended December 31, 2004 by $0.3 million and $1.2 million, respectively. On October 22, 2004, CMS published final payment rates for the period beginning January 1, 2005 and ending December 31, 2005 that we estimate will increase our annual revenues by $0.8 million (2.1%).

     Medicaid.   Medicaid is a state-administered program financed by state funds and federal matching funds. The program provides for medical assistance to the indigent and certain other eligible persons. Although administered under broad federal regulations, states are given flexibility to construct programs

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and payment methods. Each state in which we operate nursing facilities has its own unique Medicaid reimbursement program. State Medicaid programs include systems that will reimburse a nursing facility for reasonable costs it incurs in providing care to its patients, based upon cost from a prior base year, adjusted for inflation and per diems based upon patient acuity.

     The following table sets forth the average amounts of Medicaid revenues per patient, per day, recorded by our skilled nursing ("SNF") and hospital facilities for the years ended December 31:

     The 1997 Act repealed the "Boren Amendment" federal payment standard for payments to Medicaid nursing facilities. This repeal gave the states greater flexibility in setting payment rates for nursing facilities. Medicaid outlays are a significant component of state budgets, and there have been increased cost containment pressures on Medicaid outlays for nursing homes. It is not certain whether reductions in Medicaid rates will be imposed in the future for any states in which we operate.

     Nine of the states that we operate in impose a provider tax against nursing homes as a method of increasing federal matching funds paid to those states for Medicaid: Alabama, Georgia, Massachusetts, New Hampshire, North Carolina, Ohio, Tennessee, Washington and West Virginia. In addition, California recently submitted a provider tax program to CMS for approval. Those states that have imposed the provider tax have used the matching funds to fund Medicaid reimbursement rates paid to nursing homes, although the amount of the funding varies by state. As a result of North Carolina's provider tax, which was the only state to implement a provider tax in 2004, our net Medicaid revenues increased by $4.9 million in North Carolina. If CMS approves California's provider tax, we estimate our net Medicaid revenues will increase $1.4 million (4.4%) for August 1, 2004 through July 31, 2005 and an additional $2.4 million (7.5%) for August 1, 2005 through July 31, 2006 above July 2004 revenues for the facilities we currently operate. Under current rules, the provider tax cannot exceed six percent of revenues. President Bush included in his Federal fiscal year 2006 budget proposal a phase down of the allowable tax rate from six percent to three percent of revenues over the next ten years, which if enacted will reduce the federal matching funds for states that exceed the three percent limit. It is not certain whether a reduction in federal matching funds will result in reduced Medicaid rates.

     Other Reimbursement Matters. Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment by payors during the settlement process. Under cost-based reimbursement plans, payors may disallow, in whole or in part, requests for reimbursement based on determinations that certain costs are not reimbursable or reasonable or because additional supporting documentation is necessary. We recognize revenues from third-party payors and accrue estimated settlement amounts in the period in which the related services are provided. We estimate these settlement balances by making determinations based on our prior settlement experience and our understanding of the applicable reimbursement rules and regulations. The majority of Medicaid balances are settled two to three years following the provision of services.

     Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid. This focus has not been limited to skilled nursing facilities, but includes other services provided by us, such as therapy services. We cannot at this time predict the extent to which these proposals will be adopted or, if adopted and implemented, what effect, if any, such proposals will

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have on us. Efforts to impose reduced coverage, greater discounts and more stringent cost controls by government and other payors are expected to continue.

     We receive approximately 37.0% of our revenues from private insurance, long-term care facilities that utilize our specialty medical services, self-pay facility residents, and other third party payors. These private third party payors are continuing their efforts to control healthcare costs through direct contracts with healthcare providers, increased utilization review and greater enrollment in managed care programs and preferred provider organizations. These private payors increasingly are demanding discounted fee structures and the assumption by healthcare providers of all or a portion of the financial risk.

     State and local agencies survey all skilled nursing facilities on a regular basis to determine whether such facilities are in compliance with governmental operating and health standards and conditions for participation in government sponsored third-party payor programs. Although compliance with such regulatory requirements can increase our operating costs, it is our policy to maintain compliance with all regulatory requirements. From time to time, however, we receive notice of noncompliance with various requirements for Medicare/Medicaid participation or state licensure. We review such notices for factual correctness, and based on such reviews, either take appropriate corrective action and/or challenge the stated basis for the allegation of noncompliance. Where corrective action is required, we work with the reviewing agency to create mutually agreeable measures to be taken to bring the facility or service provider into compliance. Under certain circumstances, the federal and state agencies have the authority to take adverse actions against a facility or service provider, including the imposition of monetary fines, bans on admissions, civil monetary penalties and the decertification of a facility or provider from participation in the Medicare and/or Medicaid programs or licensure revocation. When appropriate, we vigorously contest such sanctions. Challenging and appealing notices or allegations of noncompliance can require significant legal expenses and management attention. (See "Item 3 - Legal Proceedings.")

     Various states in which we operate facilities have established minimum staffing requirements or may establish minimum staffing requirements in the future. Our ability to satisfy such staffing requirements will depend upon our ability to attract and retain qualified healthcare professionals, including nurses, certified nurse's assistants and other staff. Failure to comply with such minimum staffing requirements may result in the imposition of fines or other sanctions.

     Most states in which we operate have statutes which require that prior to the addition or construction of new nursing home beds, the addition of new services or certain capital expenditures in excess of defined levels, we first must obtain a Certificate of Need which certifies that the state has made a

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determination that a need exists for such new or additional beds, new services or capital expenditures. The certification process is intended to promote quality health care at the lowest possible cost and to avoid the unnecessary duplication of services, equipment and facilities.

     We are subject to federal and state laws that govern financial and other arrangements between healthcare providers. These laws often prohibit certain direct and indirect payments or fee-splitting arrangements between healthcare providers that are designed to induce the referral of patients to, or the recommendation of, a particular provider for medical products and services. These laws include:

     False claims are prohibited pursuant to criminal and civil statutes. Criminal provisions prohibit filing false claims or making false statements to receive payment or certification under Medicare or Medicaid or failing to refund overpayments or improper payments. Civil provisions prohibit the knowing filing of a false claim or the knowing use of false statements to obtain payment. Suits alleging false claims can be brought by individuals, including employees and competitors.

     In December 2000, the federal government released the final privacy rules of the Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). The rules provide for, among other things, (i) giving consumers the right and control over the release of their medical information, (ii) the establishment of boundaries for the use of medical information, and (iii) civil or criminal penalties for violation of an individual's privacy rights. In addition, HIPAA also implemented standardized transaction formats and billing codes for documenting medical services for healthcare providers that submit claims electronically.

     These privacy regulations apply to "protected health information," which is defined generally as individually identifiable health information transmitted or maintained in any form or medium, excluding certain education records and student medical records. The privacy regulations limit a provider's use and disclosure of most paper, oral and electronic communications regarding a patient's past, present or future physical or mental health or condition, or relating to the provision of healthcare to the patient or payment for that healthcare.

     HIPAA's security regulations were finalized in February 2003 and will become effective in April 2005. The security regulations require us to ensure the confidentiality, integrity, and availability of all electronic protected health information that we create, receive, maintain or transmit. We must protect against reasonably anticipated threats or hazards to the security of such information and the unauthorized use or disclosure of such information.

     We entered into a Corporate Integrity Agreement (the "CIA") with the Health and Human

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Services/Office of Inspector General ("HHS/OIG") in July 2001 and it became effective on February 28, 2002. We implemented further internal controls with respect to our quality of care standards and Medicare and Medicaid billing, reporting and claims submission processes and engaged an independent third party to act as Quality Monitor and Independent Review Organization under the CIA. A breach of the CIA could subject us to substantial monetary penalties and exclusion from participation in Medicare and Medicaid programs.

     We also entered into a Permanent Injunction and Final Judgment ("PIFJ") with the state of California on October 3, 2001. The PIFJ requires specific staff training, physical plant inspection and modification, and reporting requirements that are in addition to requirements of the CIA. The PIFJ also requires us to issue to the State reports similar to those delivered to the HHS/OIG pursuant to the CIA. The California Attorney General's office has stated that it believes that we have breached the PIFJ and if we are unable to defend that claim, we could be subject to substantial monetary penalties.

     Our compliance program, referred to as the "Compliance Process," was initiated in 1996. It has evolved as the requirements of federal and private healthcare programs have changed. Significant refinements were initiated in 2001 to parallel requirements of the HHS/OIG compliance guidelines, the CIA, and the PIFJ. There are seven principal elements to the Compliance Process, which integrate the CIA and PIFJ requirements:

     Written Policies, Procedures and Standards of Conduct.  Our business lines have extensive policies and procedures ("P&Ps") modeled after applicable laws, regulations, government manuals and industry practices and customs. The P&Ps govern the clinical, reimbursement, and operational aspects of each subsidiary. To emphasize adherence to our P&Ps, we publish and distribute a Code of Conduct and an employee handbook.

     Designated Compliance Officer and Compliance Committee. We have a Corporate Compliance Officer whose responsibilities include, among other things: (i) overseeing the Compliance Process; (ii) overseeing compliance with the CIA, PIFJ, and functioning as the liaison with the external monitors and federal government on matters related to the Compliance Process, CIA, and PIFJ; (iii) reporting to the Board of Directors, the Compliance Committee of the Board of Directors, and senior corporate managers on the status of the Compliance Process; and (iv) overseeing the coordination of a comprehensive training program which focuses on the elements of the Compliance Process and employee background screening process.  We also maintain a Corporate Compliance Committee, which includes the Chief Executive Officer, Chief Financial Officer, General Counsel, Senior Vice President of Human Resources, President and Executive Vice President of SunBridge, and the C orporate Compliance Officer. This Committee meets regularly to discuss compliance-related issues. Compliance matters are also reported to the Compliance Committee of the Board of Directors on a regular basis. The Compliance Committee is comprised solely of independent directors.

     Effective Training and Education. Every employee, director and officer is trained on the Compliance Process, Code of Conduct, and CIA. All California administrators are trained on the PIFJ, as required. Training also occurs for appropriate employees in applicable provisions of the Medicare and Medicaid laws, fraud and abuse prevention, clinical standards, and practices, and claim submission and reimbursement P&Ps.

     Effective Lines of Communication. Employees are encouraged to report issues of concern without fear of retaliation using a Four Step Reporting Process, which includes the toll-free "Sun Quality Line." The Four Step Reporting Process encourages employees to discuss clinical, ethical, or financial concerns with supervisors and local management since these individuals will be most familiar with the laws,

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regulations, and policies that impact their concern. The Sun Quality Line is an always-available option that may be used for anonymous reporting if the employee so chooses. Reported concerns are internally reviewed and proper follow-up is conducted.

     Internal Monitoring and Auditing. Our Compliance Process, in accordance with the CIA, puts internal controls in place to meet the following objectives effectively: (i) claims, reimbursement submissions, cost reports and source documents are accurate; (ii) patient care, services, and supplies are provided as required by applicable standards and laws; (iii) clinical assessment and treatment documentation are accurate; and (iv) CIA and PIFJ are implemented and obligations are met (e.g., background checks, licensing and training). Each business line monitors and audits compliance with P&Ps and other standards to ensure that the objectives listed above are met. Data from these internal monitoring and auditing systems are analyzed and acted up through a quality improvement process. We have designated the subsidiary presidents and each member of the operations management team as Compliance Liaisons. Each Compliance Liaison is responsible for making cert ain that all requirements of the Compliance Process are completed at the operational level for which the Compliance Liaison is responsible.

     Enforcement of Standards. Our policies, the Code of Conduct and the employee handbook as well as all associated training materials clearly indicate that employees who violate our standards will be subjected to discipline. Sanctions range from oral warnings to suspensions and/or to termination of employment. We have also adopted a proactive approach to offset the need for punitive measures. First, we have implemented employee background review practices that surpass industry standards. Second, as noted above, we devote significant resources to employee training. Finally, we have adopted a performance management program intended to make certain that all employees are aware of what duties are expected of them and understand that compliance with policies, procedures, standards and laws related to job functions is required.

     Responses to Detected Offenses and Development of Corrective Actions.  Correction of detected misconduct or a violation of our policies is the responsibility of every manager. As appropriate, a manager is expected to develop and implement corrective action plans and monitor whether such actions are likely to keep a similar violation from occurring in the future.

     Sun Healthcare Group, Inc. was incorporated in 1993. Our principal executive offices are located at 18831 Von Karman, Suite 400, Irvine, CA 92612, and our telephone number is (949) 255-7100. We maintain a website at www.sunh.com. Through the "About Our Company," "Investor Information" and "SEC Filings" links on our website, we make available free of charge, as soon as reasonably practicable after such information has been filed or furnished to the SEC, each of our filings with the SEC, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act.

     Information provided in this Form 10-K contains "forward-looking" information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the "Act"). All statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, lease restructuring, business strategy, budgets, projected costs and capital expenditures, competitive position, growth opportunities, plans and objectives of management for future operations and words such as

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"anticipate," "believe," "plan," "estimate," "expect," "intend," "may" and other similar expressions are forward-looking statements. The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the "safe harbor" provisions of the Act. We caution investors that any forward-looking statements made by us are not guarantees of future performance and that actual results may differ materially from those in the forward-looking statements as a result of various factors, including, but not limited to, those set forth below and elsewhere herein. We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.

     Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements as a result of, but not limited to, the factors set forth below. You should carefully consider the risks described herein before making any investment decisions to buy securities of Sun Healthcare Group, Inc. There may be additional risks that we do not presently know of or that we currently deem immaterial.

     Reductions in the reimbursement rates paid by Medicare and State Medicaid agencies to our inpatient operations would directly impact our net earnings because we are not able to reduce operating expenses associated with our facilities to compensate for reductions in those revenues. We derive approximately 78.2% of our inpatient revenues for continuing operations from Medicare and Medicaid. Federal and state governments continue to focus on methods to curb spending on health care programs such as Medicare and Medicaid. For example, President Bush's proposed budget for 2006 includes the following provisions that could materially and adversely affect our results of operations and financial condition if the budget is adopted as proposed: (i) refinements to the RUG payment system that we estimate could reduce our Medicare reimbursements by approximately $10.3 million in 2006, (ii) a 30% reduction in Part A bad debt reimbursement that we estimate could reduce our Medicare reimbursements by approximately $0.7 million in 2006 and escalating in succeeding years, and (iii) a phase down in the allowable State provider tax rates that would reduce the available federal matching funds to those states, and we are unable to estimate the impact of this on our Medicaid reimbursements at this time. However, it is too early to determine whether those proposals will be implemented. (See "Item 1 Business - Revenues from Medicare, Medicaid and Other Sources.")

     Reductions in the reimbursement rates paid by Medicare and State Medicaid agencies to our ancillary operations could have a material adverse effect on our financial position, results of operations and cash flows. The moratorium on the imposition of therapy caps is scheduled to expire on December 31, 2005. If the therapy caps are implemented, we estimate that our annual rehabilitation therapy services revenues and our inpatient services revenues would decrease by approximately $15.2 million and $1.0 million, respectively. (See "Item 1 Business - Revenues from Medicare, Medicaid and Other Sources.")

     We rely primarily on self-funded insurance programs for general and professional liability claims against us, and as of December 31, 2004, we had reserved $104.7 million for our potential liability for such claims but we had only pre-funded $3.1 million for such claims. Nursing home operators, including SunBridge, are subject to lawsuits alleging negligence resulting in injury or death to residents of the homes. We currently have numerous patient care lawsuits pending against us, as well as other types of lawsuits, many of which relate to facilities that we no longer operate. Since January 2000, we have relied upon self-funded insurance programs for general and professional liability claims up to a base amount per claim and an aggregate per location, which amounts we are responsible for funding, and we have obtained excess insurance policies for claims above those amounts. The programs have the following

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coverages that we are responsible for self-funding: (i) for events occurring from January 1, 2000 to December 31, 2002, $1.0 million per claim, and $3.0 million aggregate per location; (ii) for claims made in 2003, $10.0 million per claim; and (iii) for claims made in 2004 and 2005, $10.0 million per claim with a single $5.0 million excess layer that attaches at $5.0 million of liability, available for claims made in 2004, 2005 and 2006. There is a risk that the amounts funded to our programs of self-insurance and future cash flows may not be sufficient to respond to all claims asserted under those programs. (See "Item 3 Legal Proceedings" and "Note 11 - Commitments and Contingencies.")

     Our healthcare operations are extensively regulated and adverse determinations against us could result in severe penalties including loss of licensure and decertification. In the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, civil and criminal investigations, examinations, audits, site visits and surveys, some of which are non-routine. If we are found to have engaged in improper practices, we could be subject to civil, administrative or criminal fines, penalties or restitutionary relief, and reimbursement authorities could also seek our suspension or exclusion from participation in their program. The exclusion of a facility from participating in Medicare or Medicaid would have a material adverse effect on the facility's financial position, results of operations and cash flows. (See "Item 1 - Business - Federal and State Reg ulatory Oversight" and "Item 3 - Legal Proceedings.")

     If we are unable to collect our accounts receivable, our financial condition, results of operations, and cash flows will be adversely affected. Our total bad debt expense for the years ended December 31, 2004, 2003 and 2002 was $11.9 million, $19.1 million and $15.2 million, respectively, of which $5.2 million, $9.3 million and $10.6 million related to discontinued operations for the years ended December 31, 2004, 2003 and 2002, respectively. Our total allowance for doubtful accounts was $40.3 million and $67.1 million at December 31, 2004 and 2003, respectively, of which $22.4 million and $47.2 million related to discontinued operations at December 31, 2004 and December 31, 2003, respectively.

     We continue to be affected by an industry-wide shortage of qualified facility care-provider personnel and increasing labor costs. We, and other providers in the long-term care industry, have had and continue to have difficulties in retaining qualified personnel to staff our long-term care facilities, particularly nurses, and in such situations we may be required to use temporary employment agencies to provide additional personnel. The labor costs are generally higher for temporary employees than for full-time employees. In addition, many states in which we operate have increased minimum staffing standards. As minimum staffing standards are increased, we may be required to retain additional staffing. In addition, in recent years we have experienced increases in our labor costs primarily due to higher wages and greater benefits required to attract and retain qualified personnel and to increase staffing levels in our long-term and subacute care facilit ies.

     We are required to maintain in effect a registration statement with respect to the stock placed with investors in our February 2004 private placement and we will be subject to monetary penalties if we are unable to do so. In connection with our private placement of our common stock and warrants to purchase common stock to investors (the "Purchasers") in February 2004, we entered into Registration Rights Agreements with the Purchasers. Subject to certain exceptions, we were required to file a registration statement with the Securities and Exchange Commission (the "SEC") to register the shares for resale by the Purchasers of the common stock and the common stock to be issued upon the exercise of the warrants issued to the investors in the private placement. Subject to certain exceptions, in the event that the registration statement ceases to be effective for an aggregate of 30 trading days, then the Registration Rights Agreement requires us to pay liquidated damages of approximately $312,000 to those Purchasers who continue to hold the shares purchased in the private placement. The damages are calculated per 30-

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day period equal to one percent of the gross proceeds received by us from such purchases in the private placement. As of March 1, 2005, we were in full compliance with the Registration Rights Agreement.

     The Bureau of Medi-Cal Fraud and Elder Abuse continues to allege that we have violated the terms of the October 2001 Permanent Injunction and Final Judgment ("PIFJ.") We are unable to determine the remedies that a court may ultimately award against us if we are found to have violated the Permanent Injunction. An adverse outcome in these matters could have a material adverse effect on our financial position, results of operations and cash flows. We believe that we are, in fact, currently in full compliance with the PIFJ. (See "Item 3 - Legal Proceedings.")

     Healthcare costs have been rising and are expected to continue to rise at a rate higher than that anticipated for consumer goods as a whole. Our operations could be adversely affected if we experience significant delays in receiving reimbursement rate increases from Medicaid and Medicare sources for our labor and other costs.

     Inpatient Facilities. As of March 1, 2005, we operated 104 long-term care, subacute care and assisted living facilities and we leased office space for administrative purposes in three locations in three states. We operated 89 facilities pursuant to long-term operating leases or subleases and 15 owned facilities. We consider our properties in general to be in good operating condition and suitable for the purposes for which they are being used. Our facilities that are leased are subject to long-term operating leases or subleases which require us, among other things, to fund all applicable capital expenditures, taxes, insurance and maintenance costs. Our facilities that are owned are subject to mortgage financing. The annual rent payable under most of the leases generally increases based on a fixed percentage or increases in the U.S. Consumer Price Index. Many of the leases contain renewal options to extend the term. Substantially all of our leasehold interests serve as collateral for our obligations under our Loan Agreements.

     Our aggregate occupancy percentages for all of our long-term care, subacute care and assisted living facilities in the United States, on a same store basis, were 90.64%, 89.77% and 90.43% for the years ended December 31, 2004, 2003 and 2002, respectively. The percentages were computed by dividing the average daily number of beds occupied by the total number of available beds for use during the periods indicated. However, we believe that occupancy percentages, either individually or in the aggregate, should not be relied upon alone to determine the performance of a facility. Other factors include, among other things, the sources of payment, terms of reimbursement and the acuity level of the patients.

     The following table sets forth certain information concerning the 104 long-term care, subacute care and assisted living facilities that we operated as of March 1, 2005, which consisted of 87 skilled nursing facilities, eight assisted living facilities, six mental health facilities, and three specialty acute care hospitals. As part of our restructuring efforts, we expect to divest three of the facilities in the table during 2005 representing approximately 203 licensed and 180 available beds.

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     Rehabilitation Services. As of March 1, 2005, we leased four HTA offices, 10 office spaces and five patient care delivery sites in 12 states to operate our SunDance rehabilitation therapy business.

     Medical Staffing Services. As of March 1, 2005, we leased office space in 25 locations in 16 states to operate our CareerStaff medical staffing business.

     Home Health Services. As of March 1, 2005, we leased office space in 19 locations in two states to operate our SunPlus home health business.

     Laboratory and Radiology. As of March 1, 2005, we leased 19 locations in three states to operate our SunAlliance medical laboratory and mobile radiology business.

     Corporate and Other. We lease our executive offices in Irvine, California and we lease one and own three corporate office buildings in Albuquerque, New Mexico. As of March 1, 2005, we leased two locations in two states to operate our other businesses.

     In February 2003, the Bureau of Medi-Cal Fraud and Elder Abuse (the "BMFEA"), which is a division of the Office of the Attorney General of the State of California, alleged that we violated the terms of the Permanent Injunction and Final Judgment (the "PIFJ") entered in during October 2001. Those allegations were reiterated in correspondence we received from the BMFEA in October 2004 and 

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again in correspondence received in February 2005. Pursuant to the PIFJ, we are enjoined from engaging in violations of federal or state statutes or regulations governing the operation of health care facilities in the State of California. The BMFEA has continued to allege that our California facilities have had inadequate staffing, training and supervision. To remedy these alleged violations, the BMFEA requested that we pay their costs of the investigation and to audit our operations in California, and, initially, requested an unspecified cash penalty. We believe that we are, in fact, currently in full compliance with the PIFJ; however, unless the matter is settled, it is likely that the BMFEA will initiate one or more legal proceedings against us to assert a violation. We cannot predict the remedies that a court may ultimately award against us, or the cost to us resulting from an adverse outcome in this matter. An adverse outcome in this matter could result in a material adverse impac t to our financial statements and cashflows. We intend to defend this matter vigorously.

     In January 2004, 12 caregivers, now former employees of SunBridge Care and Rehab for Escondido-East, were arraigned on charges brought by the California Attorney General with respect to allegations that care given to an elderly woman resident was deficient. The court dismissed all charges against the twelve defendants in June 2004. In September 2004, the California Attorney General refiled misdemeanor charges against the same defendants, certain of which charges were likewise dismissed in December 2004, but were once again refiled in December 2004. SunBridge Care and Rehab for Escondido-East is a skilled nursing facility in Escondido, California that was formerly operated by Care Enterprises West, an indirect subsidiary of Sun Healthcare Group, Inc. Care Enterprises West divested its interest in the operations of the facility to an unrelated third party at the end of October 2004. Although Care Enterprises West has paid the costs for the defense of these individuals in this matter to date, neither Sun Healthcare Group, Inc. nor Care Enterprises West has been charged with any wrongdoing.

     On June 1, 2004, we commenced a declaratory relief action in the Orange County, California Superior Court in which Steadfast Insurance Company, American International Group ("AIG") and certain of AIG's subsidiaries are parties. The action seeks, among other things, a judicial determination that the carrier providing coverage under our excess/umbrella insurance policy for the 2000 through 2002 policy years is obligated to provide first dollar insurance coverage for those three policy years pursuant to the terms of the excess/umbrella policy. That policy provides that the excess/umbrella policy continues in force as underlying insurance upon exhaustion of the underlying primary insurance policy. If we prevail in this action, such a judicial determination would eliminate a portion of our self-insured liabilities for general and professional liability claims. We can give no assurances that we will in fact prevail and, accordingly, our financial statements refl ect no positive adjustment for the drop down of the excess/umbrella coverage asserted in this litigation.

     We are a party to various other legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our facilities, claims relating to employment and commercial matters. In certain states in which we have had significant operations, insurance coverage for the risk of punitive damages arising from general and professional liability litigation may not be available due to state law public policy prohibitions. There can be no assurance that we will not be liable for punitive damages awarded in litigation arising in states for which punitive damage insurance coverage is not available.

     We operate in industries that are extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, these industries are frequently subject to the regulatory supervision of fiscal

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intermediaries. If a provider is ever found by a court of competent jurisdiction to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief, and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations and cash flows.

     No matters were submitted to a vote of security holders during the fourth quarter of 2004.

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     We began issuing our common stock on February 28, 2002 as part of our Plan of Reorganization. Our common stock began trading under the symbol "SUHG.OB" on the Over-the-Counter ("OTC") Bulletin Board on April 2, 2002 and then under the symbol "SUNH" on the Nasdaq National Market on March 10, 2004. The following table shows the high and low sale prices for the common stock as reported by the OTC Bulletin Board and the Nasdaq National Market for the periods indicated:

     There were approximately 4,500 holders of record of our common stock as of March 1, 2005. We have never paid nor declared any dividends on our common stock. Our Revolving Loan Agreement prohibits us from paying any dividends or making any distributions to the stockholders of Sun Healthcare Group, Inc. We did not repurchase any shares of our common stock during the fourth quarter of 2004.

     The following selected consolidated financial data for the periods indicated have been derived from our consolidated financial statements. The financial data set forth below should be read in connection with "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations" and with our consolidated financial statements and related notes thereto (in thousands, except per share data):

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      We are a nationwide provider of long-term, subacute and related speciality healthcare services in the United States. We currently operate through various direct and indirect subsidiaries that engage in the following five principal business segments: (i) inpatient services, primarily skilled nursing facilities, (ii) rehabilitation therapy services, (iii) medical staffing services, (iv) home health services and (v) laboratory and radiology services. For continuing operations, during the year ended December 31, 2004, we received approximately 26.5% of our revenues from Medicare, 36.5% from Medicaid, and 37.0% from private insurance, self-pay residents, other third party payors and long-term care facilities that utilized our specialty medical services. The sources and amounts of our inpatient services revenues are determined by a number of factors, including the number of licensed beds and occupancy rates of our facilities, the acuity level of patients and the rates of reimbursement among payors.

     Our discussion and analysis of the financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the use of

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estimates and judgments that affect the reported amounts and related disclosures of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ materially from these estimates. We believe the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of the consolidated financial statements.

(a)  Net Revenues

     Net revenues consist of long-term and subacute care revenues, rehabilitation therapy revenues, medical staffing services revenues, home health revenues and laboratory and radiology revenues. Net revenues are recognized as services are provided. Revenues are recorded net of provisions for discount arrangements with commercial payors and contractual allowances with third-party payors, primarily Medicare and Medicaid. Net revenues realizable under third-party payor agreements are subject to change due to examination and retroactive adjustment. Estimated third-party payor settlements are recorded in the period the related services are rendered. The methods of making such estimates are reviewed periodically, and differences between the net amounts accrued and subsequent settlements or estimates of expected settlements are reflected in current results of operations, when determined.

(b)  Accounts Receivable and Related Allowance

     Our accounts receivable relate to services provided by our various operating divisions to a variety of payors and customers. The primary payors for services provided in long-term and subacute care facilities that we operate are the Medicare program and the various state Medicaid programs. The rehabilitation therapy service operations provide services to patients in nonaffiliated long-term, rehabilitation and acute care facilities. The billings for those services are submitted to the nonaffiliated facilities. Many of the nonaffiliated long-term care facilities receive a large majority of their revenues from the Medicare program and the state Medicaid programs.

     Estimated provisions for doubtful accounts are recorded each period as an expense to the consolidated statements of operations. In evaluating the collectibility of accounts receivable, we consider a number of factors, including the age of the accounts, changes in collection patterns, the financial condition of our customers, the composition of patient accounts by payor type, the status of ongoing disputes with third-party payors and general industry conditions. Any changes in these factors or in the actual collections of accounts receivable in subsequent periods may require changes in the estimated provision for loss. Changes in these estimates are charged or credited to the results of operations in the period of the change.

     The allowance for uncollectible accounts related to facilities that we currently operate is computed by applying a bad debt percentage to the individual accounts receivable aging categories based on historical collections. An adjustment is then recorded each month to adjust the allowance based on the analysis. In addition, a retrospective collection analysis is performed within each operating company to test the adequacy of the reserve on a quarterly basis.

     The allowance for uncollectible accounts related to facilities that we have divested was based on a percentage of outstanding accounts receivable at the time of divestiture and was recorded in gain or loss on disposal of discontinued operations, net. As collections are recognized, the allowance will be adjusted as appropriate. This percentage was 40% in 2002 and was adjusted to 30% in the fourth quarter of 2003. The percentages were developed from historical collection trends of our divestitures. Due to favorable collections, $6.5 million of the reserve was recovered in the year ended December 31, 2004. As of December 31, 2004, we had $1.3 million in accounts receivable for divested operations, net of $20.2 million of allowance for doubtful accounts.

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(c)  Insurance

     We self-insure for certain insurable risks, including general and professional liability, workers' compensation liability and employee health insurance liability through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs. Provisions for estimated reserves, including incurred but not reported losses, are provided in the period of the related coverage. An independent actuarial analysis is prepared twice a year to determine the adequacy of the self-insurance obligations booked as liabilities on our financial statement. The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any adjustments r esulting there from are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves. Effective with the policy period beginning January 1, 2002, we discount our workers' compensation reserves based on a 4% discount rate. At December 31, 2004, the discounting of these policy periods resulted in a reduction to our reserves of approximately $7.5 million.

     Based on the results of the actuarial analysis prepared as of September 30, 2002, which considered nationwide nursing home trends that showed significant increases in patient care liability costs, we recorded a pre-tax charge of $20.0 million for the ten months ended December 31, 2002 related to an increase in patient care liability costs for prior policy years. Based on the results of the actuarial analysis, we recorded a net pre-tax charge of $0.4 million for the year ended December 31, 2003 related to patient care and workers' compensation liability costs. Based on the results of the actuarial analysis we recorded a net pre-tax credit of $17.7 million for the year ended December 31, 2004 related to improvement in claim trends primarily for prior year policies for patient care and workers' compensation liability costs.

(d) Impairment of Assets

Goodwill

     Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ("SFAS No. 142") established new rules on the accounting for goodwill and other intangible assets. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized; however, they are subject to annual impairment tests as prescribed by the statement. Intangible assets with definite lives continue to be amortized over their estimated useful lives.

     Pursuant to SFAS No. 142, we perform our annual goodwill impairment analysis during the fourth quarter for each reporting unit that constitutes a business for which discrete financial information is produced and reviewed by operating segment management. We determine impairment by comparing the net assets of each reporting unit to their respective fair values. We determine the estimated fair value of each reporting unit using a discounted cash flow analysis. In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment loss is measured by the difference between the goodwill carrying value and the implied fair value.

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 SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

     For the ten months ended December 31, 2002, we recorded a goodwill impairment of $231.1 million within the following reporting units: (i) long-term care facilities within certain states, $104.9 million in the aggregate; (ii) SunDance Rehabilitation Corporation, which operates our therapy business, $57.0 million; (iii) SunScript Pharmacy Corporation, our pharmaceutical services operations which were sold in July 2003 and classified in discontinued operations, $64.5 million; (iv) CareerStaff Unlimited, Inc., which operates our medical staffing business, no impairment; and (v) Shared Healthcare Systems, our software development company which was sold in November 2003 and classified in discontinued operations, $4.7 million. We did not record a goodwill impairment for the years ended December 31, 2003 and December 31, 2004. As of December 31, 2004, we had $0.4 million in goodwill.

Indefinite Life Intangibles

     Pursuant to SFAS No. 142, we evaluate the recoverability of the trademarks by comparing the asset's respective carrying value to estimates of fair value. We determine the estimated fair value of each trademark through a discounted cash flow analysis. The Reorganized Company recorded $34.6 million in trademarks under fresh-start accounting based on an independent and separate valuation report of the fair value of our intangible assets as of March 1, 2002. Our trends of financial performance subsequent to emergence from bankruptcy proceedings, the Medicare "Cliff" impact and increases in patient care liability claims and retention levels and workers' compensation insurance costs represented indicators of impairment. As a result, we internally prepared an impairment analysis using discounted cash flows in order to estimate the fair value of Indefinite Life Intangibles. The analysis resulted in an impairment of $26.0 million for the ten months ended D ecember 31, 2002 within the following segments: (i) $0.7 million related to SunDance Rehabilitation Corporation, which operates our therapy business, (ii) $7.2 million related to SunScript Pharmacy Corporation, our pharmaceutical services operations which were sold in July 2003 and classified in discontinued operations, (iii) $0.9 million related to CareerStaff Unlimited, Inc., which operates our medical staffing business and (iv) $17.2 million within our Corporate segment. We did not record an impairment to our Indefinite Life Intangibles for the years ended December 31, 2003 and December 31, 2004.

Finite Life Intangibles

     Pursuant to SFAS No. 142, we evaluate the recoverability of the favorable lease intangibles by comparing an asset's respective carrying value to estimates of undiscounted cash flows over the life of the lease. If the carrying value of the asset exceeded the undiscounted cash flows, an impairment loss was measured by comparing the estimated fair value of the asset, based on discounted cash flows, to its carrying value. The Reorganized Company recorded $28.2 million in favorable lease intangibles under fresh-start accounting based on an independent and separate valuation report of the fair value of our assets and liabilities as of March 1, 2002. Our trends of financial performance subsequent to emergence from bankruptcy proceedings, the Medicare "Cliff" impact and increases in patient care liability claims and retention levels and workers' compensation insurance cost represented indicators of impairment. As a result, at December 31, 2002 and 2003 we internally prepared an impairment analysis using discounted cash flows in order to estimate the fair value of Finite Life Intangibles. The analysis resulted in an impairment of $24.0 million and $0.5 million for the ten months ended December 31, 2002 and for the year ended December 31, 2003, respectively, within our Inpatient Services segment. We did not record an impairment to our Finite Life Intangibles for the year ended December 31, 2004.

Long-Lived Assets

     The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS No. 144"),

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which addresses financial accounting and reporting for the impairment of long-lived assets (other than goodwill and indefinite lived intangibles) and for long-lived assets to be disposed of. SFAS No. 144 requires impairment losses to be recognized for long-lived assets used in operations when indicators of impairment are present and the estimated undiscounted cash flows are not sufficient to recover the assets' carrying amounts. The impairment loss is measured by comparing the estimated fair value of the asset, usually based on discounted cash flows, to its carrying amount. In accordance with SFAS No. 144, we assess the need for an impairment write-down when such indicators of impairment are present.

     2004. During the fourth quarter of 2004, we recorded pretax charges totaling approximately $1.0 million for asset impairments. The asset impairment charges related to the following:

2003. During the fourth quarter of 2003, we recorded pretax charges totaling approximately $2.3 million for asset impairments. The asset impairment charges consisted of the following:

2002. During the fourth quarter of 2002, we recorded pretax charges totaling approximately $126.7 million for asset impairments. The asset impairment charges consisted of the following:

     The October 1, 2002 elimination of certain funding under the Medicare program and the increase in our patient care liability costs affected our 2002 and future cash flows, and therefore, the fair values of each of our asset groups. This event led to an impairment assessment on each of our asset groups, including:

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     In estimating the undiscounted cash flows for the 2002 impairment assessment, we primarily used our internally prepared budgets and forecast information including adjustments for the following items: Medicare and Medicaid funding; overhead costs; capital expenditures and patient care liability costs. We also considered our plans to transition under-performing long-term care facilities, which accounted for approximately 56% of our facilities, to new operators. Since indicators of impairment were present and the undiscounted cash flows were not sufficient to recover the assets' carrying amounts, the impairment loss was measured by comparing the estimated fair value of the assets to their carrying amount. In order to estimate the fair values of the entities, we used a discounted cash flow approach. That assessment resulted in an impairment related to the under-performing facilities of approximately $53.6 million.

Long-Lived Assets to be Disposed Of

     SFAS No. 144 requires that long-lived assets to be disposed of be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. Therefore, discontinued operations are no longer measured at net realizable value or include amounts for operating losses that have not yet occurred. SFAS No. 144 also broadens the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. Depreciation is discontinued once an asset is classified as held for sale. During the two month period ended February 28, 2002, the Predecessor Company presented the operating results of all facilities identified for sale or disposition in discontinued operations in the consolidated statement of operations. From March 1, 2002 t o December 31, 2002, the Reorganized Company had a limited number of facilities disposed of or transferred to assets held for sale. These facilities' operating results were included in continuing operations and were immaterial to our consolidated financial position and results of operations.

     On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.

     Statement 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. Statement 123(R) permits public companies to adopt its requirements using one of two methods:

     The following table sets forth the amount and percentage of certain elements of total net revenues for the following years ended December 31, (in thousands):

     Inpatient services revenues for long-term care, subacute care and assisted living services include revenues billed to patients for therapy, medical staffing, and laboratory and radiology provided by our affiliated operations. The following table sets forth a summary of the intersegment revenues for the years ended December 31, (in thousands):

     The following table sets forth the amount of net segment income (loss) for the following years ended December 31, (in thousands):

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     In accordance with the American Institute of Certified Public Accountants Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code ("SOP 90-7,") items of expense or income that are incurred or realized by us because we were in reorganization are classified as reorganization costs in our consolidated statements of operations. As a result, net segment income (loss) does not include interest earned subsequent to October 14, 1999, the date we filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code ("Filing Date"), on cash accumulated because we are not paying our prepetition obligations. Interest earned prior to the Filing Date is included in net segment income (loss).  Debt discounts and deferred issuance costs that were written-off after the Filing Date in accordance with SOP 90-7 are not included in the net segment income (loss).  The amortization of debt discounts and deferred issuance costs prior to the Filing Date are included in net segment income (loss). Gain (loss) on sale of assets and professional fees related to the reorganization incurred subsequent to the Filing Date are excluded from net segment income (loss) which is consistent with their treatment prior to the Filing Date.

     The following discussion of the "Year Ended December 31, 2004 compared to the Year Ended December 31, 2003" is based on the financial information presented in "Note 18 - Segment Information" in our consolidated financial statements.

     Net revenues increased $34.5 million to $820.1 million for 2004 from $785.6 million for 2003. We reported a net loss for the year ended December 31, 2004 of $18.6 million compared to net income of $0.4 million for the year ended December 31, 2003.

     The net loss of $18.6 million for the year ended December 31, 2004 included:

     The net income for the year ended December 31, 2003 included:

     Net revenues increased $38.8 million, or 7.0%, to approximately $589.3 million for year ended December 31, 2004 from approximately $550.5 million for the year ended December 31, 2003. The increase in net revenues for the Inpatient Services segment was primarily the result of:

     Operating salaries and benefits expenses increased $12.8 million, or 4.5%, to approximately $298.5 million for the year ended December 31, 2004 from approximately $285.7 million for the year ended December 31, 2003. The increase was primarily due to wage increases and an increase in labor hours associated with an increase in Medicare census, offset partly with a $3.7 million decrease in health insurance costs due to improved claims experience.

     Self-insurance for workers' compensation and general and professional liability insurance decreased approximately $5.6 million, or 20.8%, to $21.3 million for the year ended December 31, 2004 as compared to $26.9 million for the year ended December 31, 2003. This decrease was comprised primarily of:

     Other operating costs increased approximately $8.4 million, or 5.5%, to $162.5 million for the year ended December 31, 2004 from $154.1 million for the year ended December 31, 2003. The increase was primarily due to:

     Facility rent expense increased $0.2 million to approximately $35.5 million for the year ended December 31, 2004 from approximately $35.3 million for the year ended December 31, 2003 due to contractually scheduled rent increases on existing leases, offset by the favorable effect of the consolidation of the Clipper partnerships (see "Note 10 - Variable Interest Entitities.")

     General and administrative expenses decreased $1.5 million, or 11.2%, to approximately $11.9 million for year ended December 31, 2004 from approximately $13.4 million for the year ended December 31, 2003. The $1.5 million decrease was primarily due to salaries and benefits expense for regional administrative and office personnel, utilities and supplies that were eliminated as part of the restructuring.

     Depreciation and amortization increased $2.1 million, or 40.4%, to approximately $7.3 million for the 2004 year from approximately $5.2 million for the 2003 year. The increase was primarily attributable to

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capital expenditures incurred for facility improvements and the additional depreciation and amortization expense associated with the consolidation of Clipper partnerships. (See "Note 10 - Variable Interest Entities.")

     The provision for losses on accounts receivable decreased $3.7 million, or 57.8%, to approximately $2.7 million for the year ended December 31, 2004 from approximately $6.4 million for the year ended December 31, 2003 due to improved monitoring of current receivables and the collection of older receivables.

     Net interest expense for the year ended December 31, 2004 was approximately $5.3 million as compared to $3.1 million for the year ended December 31, 2003. The $2.2 million, or 71.0%, increase was primarily due to the scheduled increase in expense related to debt amortization and the additional interest expense related to the consolidation of Clipper partnerships. (See "Note 10 - Variable Interest Entities.")

     Net revenues for the Rehabilitation Therapy Services segment decreased $11.2 million, or 7.8%, to approximately $133.3 million for the year ended December 31, 2004 from approximately $144.5 million for the year ended December 31, 2003. The decrease was primarily due to the decrease in nonaffiliated sales as a result of the lingering disruption of the sales cycle in 2004 due to the January 2004 termination of the contemplated sale of substantially all of the segment announced in late 2003.

     Operating salaries and benefits expenses decreased $7.2 million, or 7.3%, to approximately $91.9 million for the year ended December 31, 2004 from approximately $99.1 million for the same period in 2003. The decrease was primarily driven by the reduction of employees and reorganization of the operating structure as a result of the impact of lower revenues and a reclassification to general and administrative expenses.

     Self-insurance expenses for workers' compensation and professional liability insurances decreased $1.1 million, or 61.1%, to $0.7 million for the year ended December 31, 2004 from $1.8 million for the year ended December 31, 2003. The decrease was primarily due to costs related to improved claims experiences during the year.

     General and administrative expenses increased $2.8 million, or 77.8%, to $6.4 million for the year ended December 31, 2004 from $3.6 million for the year ended December 31, 2003. The increase was primarily due to reclassification of expenses included in operating expenses.

     Depreciation and amortization decreased $0.9 million, or 81.8%, to approximately $0.2 million for the year ended December 31, 2004 from $1.1 million for the year ended December 31, 2003. The decrease was primarily due to the reduction in property carrying values due to closures of administrative office locations in conjunction with the Inpatient Services divestitures during 2003 and the restructuring of operations in 2004.

     The provision for losses on accounts receivable decreased $0.3 million, or 16.7%, to approximately $1.5 million for the year ended December 31, 2004 from approximately $1.8 million for the year ended December 31, 2003. The decrease in expense was primarily due to improved collection and customer credit methods.

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     Net revenues from the Medical Staffing Services segment decreased $5.0 million, or 8.1%, to approximately $56.8 million for the year ended December 31, 2004 from approximately $61.8 million for the year ended December 31, 2003. The decrease was primarily the result of decreased agency staff usage within our affiliated skilled nursing facilities and hospitals.

     Operating salaries and benefits expenses were approximately $43.9 million for the year ended December 31, 2004 as compared to approximately $45.6 million for the year ended December 31, 2003, a decrease of $1.7 million, or 3.7%. The decrease was directly attributable to the decrease in revenue.

     Other operating expenses, which include contract staffing utilized to staff personnel shortages, decreased $5.8 million, or 57.4%, to $4.3 million for 2004 year from $10.1 million for the 2003 year. The decrease was primarily attributable to a decrease of $5.2 million in contract labor expense due to decreased usage by the affiliated inpatient facilities and a $0.6 million decrease in regional administrative expenses.

     General and administrative expenses increased $0.9 million, or 40.9%, to approximately $3.1 million for the year ended December 31, 2004 from approximately $2.2 million for the year ended December 31, 2003. The increase was primarily due to recruiting and retention costs associated with initiatives to attract new business and retain staff.

     Net revenues from the Home Health Services segment increased approximately $1.2 million, or 2.2%, to $56.7 million for the year ended December 31, 2004 from approximately $55.5 million for the year ended December 31, 2003. The increase in revenues was due primarily to an increase in Medicare rates.

     Operating salaries and benefits expenses increased approximately $0.2 million, or 0.5%, to $40.5 million for the 2004 year from approximately $40.3 million for the 2003 year. The increase was primarily the result of an increase in health insurance costs.

     Self-insurance expenses for workers' compensation and professional liability insurance increased approximately $0.4 million, or 23.5%, to $2.1 million for the year ended December 31, 2004 from approximately $1.7 million for the year ended December 31, 2003. The increase was primarily the result of increased workers' compensation claims expenses.

     The provision for losses on accounts receivable increased $0.3 million, or 150.0%, to approximately $0.5 million for the year ended December 31, 2004 from approximately $0.2 million for the year ended December 31, 2003. The increase was due to better than expected collections on account receivables in 2003 that did not occur in 2004.

     Net revenues from the Laboratory and Radiology Services segment decreased $0.4 million, or 2.1%, to approximately $19.0 million for the year ended December 31, 2004 from approximately $19.4 million for the year ended December 31, 2003, due primarily to a decrease in contracts in our northeast laboratory operations.

     Operating salaries and benefits expenses decreased approximately $0.2 million, or 1.9%, to $10.5 million for the 2004 year from approximately $10.7 million for the 2003 year. The decrease was

33

primarily the result of a reduction in employees driven by the decrease in revenues.

     Other operating costs increased $0.6 million, or 11.8%, to $5.7 million for the year ended December 31, 2004 from $5.1 million for the year ended December 31, 2003. This increase was due primarily to an increase in purchased and administrative services.

     General and administrative expenses were approximately $0.4 million for the year ended December 31, 2004. These costs were included in operating costs for the same period in 2003.

     The provision for losses on accounts receivable increased $0.8 million, or 88.9%, to approximately $1.7 million for the year ended December 31, 2004 from approximately $0.9 million for the year ended December 31, 2003. The increase was primarily the result of an adjustment in the mobile radiology operations on the reserve for aged receivables due to lower than expected collections.

     General and administrative costs not directly attributed to operating segments increased $0.7 million, or 1.6%, to approximately $44.1 million for the year ended December 31, 2004 from approximately $43.4 million for the year ended December 31, 2003. The increase was primarily due to:

     Net interest expense not directly attributed to operating segments decreased $10.3 million, or 74.1%, to approximately $3.6 million for the year ended December 31, 2004 from approximately $13.9 million for the year ended December 31, 2003. The decrease was primarily due to the private placement of our common stock and warrants and the payoff of substantially all of the outstanding revolving loan balance for which interest was not incurred.

     We adopted the provisions of SFAS No. 144 as of January 1, 2002, however our emergence from bankruptcy on February 28, 2002 and the adoption of fresh-start accounting as of March 1, 2002 materially changed the presentation of the consolidated financial statements of the Predecessor Company. With respect to reported operating results in a comparative of the year ended 2003 to the year ended 2002, we believe that business segment operating income of the Predecessor Company is generally not comparable to that of the Reorganized Company, therefore a discussion of segment results for the year ended December 31, 2003 as compared to the ten months ended December 31, 2002 and the two months ended February 28, 2002 is not appropriate.

     We reported net income for the year ended December 31, 2003 of $0.4 million compared to net

34

income of $1,047.4 million for the prior year. The net income for the year ended December 31, 2003 included the following:

     The net income for the prior year included a gain on extinguishment of debt of $1,498.4 million related to our emergence from bankruptcy in early 2002, an asset impairment charge of $275.5 million, a $20.0 million charge for patient care liability costs related to our inpatient services operation, a favorable adjustment of $6.0 million related to workers' compensation insurance costs primarily related to our inpatient services operation, and an $8.7 million gain on sale of assets, net, primarily due to the reversal of prepetition liabilities related to disposed facilities.

Net Revenues

     Our net revenues were $785.6 million for the year ended December 31, 2003 compared to, $942.8 million for the prior year. The decrease in net revenues of approximately $157.2 million, or 16.7% for the year ended December 31, 2003, as compared to the prior year, primarily consisted of the following:

     The increase in net revenues of $21.9 million from our inpatient services operations on a same store basis for the year ended December 31, 2003, as compared to the year ended December 31, 2002, was primarily due to the following:

     Operating salaries and benefits for the year ended December 31, 2003 were $481.3 million as compared to $564.2 million for the year ended December 31, 2002. The decrease of $82.9 million, or 14.7%, was primarily the result of personnel cost reductions that occurred commensurate with the inpatient facility divestitures and the reclassification to discontinued operations of ten months of expenses related to discontinued operations.

     With a decrease of $3.1 million, or 8.8%, for the year ended December 31, 2003 as compared to the year ended December 31, 2002, costs related to workers' compensation and general and professional liability insurance remained essentially flat year over year; however, the 2002 expenses were impacted with a net $14.0 million charge recorded in third quarter of 2002 for prior year policy exposures.

     We reported facility rent expense of $39.1 million in 2003 as compared to $61.1 million in 2002, a decrease of $22.0 million, or 36.0%. For the year ended December 31, 2003, facility rent expense for our Inpatient Services segment was approximately $32.3 million compared to $55.3 million for the same period ended December 31, 2002 due primarily to lease terminations and divestitures of inpatient facilities during 2003.

     We reported other operating expenses, general and administrative expenses and provision for losses on accounts receivable of $224.8 million for the year ended December 31, 2003 compared to $282.0 million for the same period in 2002. The decrease of approximately $57.2 million, or 20.3%, consisted of the following:

     Interest expense, net, increased to $16.9 million for the year ended December 31, 2003, as compared to $15.3 million for the same period in 2002, a $1.6 million, or 10.5%, increase, of which $2.4 million was due primarily to the recognition of interest expense at a higher effective interest rate for our term loan, offset by a $0.7 million decrease related to lower interest charges incurred due to lower carrying

36

values on our debt instruments during 2003 as compared to 2002. While we were under bankruptcy protection through the two months ended February 28, 2002, we did not record interest on essentially all of our prepetition debt. Had we not been under bankruptcy protection, our interest expense, net, for the year ended December 31, 2002 would have been approximately $38.9 million.

     Depreciation and amortization expense decreased $14.3 million, or 66.5%, to $7.2 million for the year ended December 31, 2003 as compared to $21.5 million for the same period in 2002. The decrease was primarily attributable to decreases in property carrying amounts as a result of the impairment recorded in the fourth quarter of 2002.

     We recorded a provision for income taxes of approximately $1.3 million, of which $0.6 million was related to discontinued operations, for the year ended December 31, 2003, primarily related to state income taxes. We increased our valuation allowance on our deferred tax assets by $93.3 million during 2003 to $708.8 million as of December 31, 2003. This valuation allowance was required under the guidance in Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes, " due to our historical operating performance and our cumulative net losses.

     For the year ended December 31, 2004, our net loss was $18.6 million. As of December 31, 2004, we had cash and cash equivalents of approximately $22.6 million, our working capital deficit was $30.6 million, and we had approximately $25.8 million of funds available for borrowing. We believe that our existing cash reserves, the proceeds of up to $15.0 million due to us in 2005 for the sale of our SunScript pharmacy operations in 2003, and availability for borrowing under our loan agreement will provide sufficient funds for our operations, capital expenditures and regularly scheduled debt service payments through at least the next twelve months. For the year ended December 31, 2004, the net cash decrease was approximately $3.0 million. The decrease was comprised primarily of:

     On February 20, 2004, we completed a private placement of our common stock and warrants to purchase common stock to investors. We received net proceeds of approximately $52.3 million in the private placement. We sold approximately 4.4 million shares of our common stock, and warrants to purchase approximately 2.0 million shares of our common stock (inclusive of warrants paid to the placement agent). The price paid by investors was $12.70 per unit, except for 155,400 units sold at $12.87 per unit. Each unit consisted of one share of common stock and a warrant to purchase 0.4 shares of common stock with a warrant exercise period of five years at an average exercise price of $13.05 per share.

     On March 1, 2004, we entered into an Amended and Restated Master Lease Agreement with Omega Healthcare Investors, Inc. and various of its affiliates ("Omega"). Prior to our portfolio restructuring, we leased 51 facilities from Omega. Pursuant to the new Master Lease, we continue to operate 30 facilities (including 23 long-term care facilities, one rehabilitation and one long-term care hospital, and five behavioral facilities). The new master lease also settled a combination of (i) accrued past due rent and (ii) future rent obligations that would otherwise have become due under the previously existing master leases as of March 1, 2004 by combining those amounts into "deferred base rent." Such deferred base rent accrued interest (annually compounded) at a floating rate of 375 basis points of the applicable LIBOR rate (subject to a floor rate of 6.0%.) However, in April 2004, Omega exercised its right to convert the deferred base rent and accrued interest into 760,000 shares of our common stock and $0.5 million in cash, resulting in a $4.4 million charge recorded in loss on disposal of discontinued operations, net, for the year ended December 31, 2004 and ceasing further accrual of interest on the deferred rent.

     We have substantially completed our restructuring efforts, including the restructuring of the portfolio of leases under which we operate most of our long-term care facilities. Through December 31, 2004, we had divested 133 facilities and had identified three facilities that we would seek to transition to new operators. During the two years ended December 31, 2004, we withheld approximately $28.5 million in accrued rent payments and $0.7 million of mortgage payments on facilities that we identified for transfer to new operators. As of December 31, 2004, we were released of our obligations to pay approximately $15.7 million of the withheld rent, $8.0 million was paid in settlements with landlords, $2.9 million was offset by security deposits, reducing other assets, that were used toward unpaid rent, and $1.9 million remains in other accrued liabilities and is related to divested buildings that do not have a release per a lease termination agreement .

     We have a Loan and Security Agreement with CapitalSource Finance LLC, as collateral agent, and certain other lenders (the "Revolving Loan Agreement") that, as amended on March 1, 2005, expires on March 1, 2007. (See "Note 24 - Subsequent Events.") The Revolving Loan Agreement is a $75.0 million revolving line of credit that is secured by our accounts receivable, inventory, equipment and other assets, and the stock of our subsidiaries. Pursuant to the Revolving Loan Agreement, we are paying interest (i) for Base Rate Loans at the greater of (a) prime plus 0.5% or (b) 4.75%, and (ii) for LIBOR Loans at the greater of (a) the London Interbank Offered Rate plus 3.25% or (b) 4.75%. The effective interest rate as of December 31, 2004 on borrowings under the Revolving Loan Agreement was approximately 6.16%. We had $0.6 million in borrowings outstanding on December 31, 2004. The weighted average borrowing interest rate for the period from January 1, 2004 through Decem ber 31, 2004 was 5.25%. Our borrowing availability under the Revolving Loan Agreement is generally limited to up to eighty-five percent (85%) of the value of Eligible Receivables plus eighty-five percent (85%) of the value of Eligible Divested Company Receivables, but not to exceed $75.0 million. The defined borrowing base as of December 31, 2004 was $41.1 million, net of specified reserves of $14.6 million. We are also prohibited under our

38

Revolving Loan Agreement from borrowing money from third parties without the prior consent of CapitalSource Finance. As of December 31, 2004, we had issued approximately $15.3 million in letters of credit, leaving approximately $25.8 million available to us for additional borrowing. In connection with entering into the Revolving Loan Agreement, we incurred deferred financing costs of $2.6 million, which are amortized using the effective interest method over the life of the loan agreement. For the year ended December 31, 2004, we amortized $1.6 million of these deferred financing costs. In September 2004, $0.9 million of the deferred financing costs were refunded to us.

     We incurred total net capital expenditures related primarily to improvements at existing facilities, as reflected in the segment reporting, of $12.9 million, $16.6 million and $34.7 million for the year ended December 31, 2004, the year ended December 31, 2003 and the ten month period ended December 31, 2002, respectively. These capital expenditures include those related to discontinued operations of $0.7 million, $4.6 million, and $16.1 million for the for the year ended December 31, 2004, the year ended December 31, 2003 and the ten month period ended December 31, 2002, respectively. We had construction commitments as of December 31, 2004 under various contracts of approximately $2.8 million related to improvements at facilities. During the year ended December 31, 2005, we expect to incur approximately $20.0 million in capital expenditures, related primarily to improvements at existing facilities and information system upgrades.

     On February 28, 2002, we delivered a promissory note to the United States of America as part of our settlement agreement with the federal government and $8.0 million remains outstanding under the note. The outstanding payments coming due under the promissory note are $2.0 million on February 28, 2005 and $3.0 million on each of February 28, 2006 and 2007. Interest under the promissory note is based upon the weekly average one-year constant maturity treasury yield. The effective interest rate as of December 31, 2004 was approximately 2.2%.

     We continue to negotiate settlements of bankruptcy claims for periods prior to October 14, 1999 that were filed by various State Medicaid agencies. We expect to pay in excess of approximately $2.7 million to the State Medicaid agencies to resolve these claims. The payments are expected to be made partly in cash, partly with promissory notes and potentially netted against reimbursements payable to us. We currently have $4.0 million reserved against our borrowing base agreement relating to these payments.

     We intend to file a universal shelf registration statement shortly. The title and terms of the securities to be offered under that filing and the amount of any offering to security holders has yet to be determined, but we expect the shelf to cover up to $50.0 million of potential debt and/or equity offerings. The proceeds of any such offering will likely be to fund general corporate purposes and to give us more flexibility in financing potential acquisitions. We can give no assurance that we will be able to proceed with and complete any such placement or offering on terms acceptable to us. We cannot estimate the net proceeds that we would receive or the timing of any such placement or offering.

     We intend to make strategic acquisitions of complementary businesses in 2005 and in future years utilizing our stock, cash or debt financing to enable us to capitalize on our position in the geographic

39

markets in which we operate and to expand our businesses geographically. We are unable to estimate the aggregate amount that we would incur as a purchase price for such acquisitions or the amount of working capital that we would expend during the assimilation of the acquired operations.

     We currently own a five percent interest in each of eight limited liability companies and partnerships each of which own one facility that we operate in New Hampshire. In April 2004, we entered into an agreement with the owners of remaining interests in those eight entities, and with the owner of a ninth entity which also owns a facility in New Hampshire that we operate (collectively, the "Owners"). That agreement granted us options, exercisable sequentially over a period of seven years, pursuant to which we can acquire up to 100 percent of the ownership of those nine entities for an aggregate amount of up to approximately $10.3 million, subject to reduction in certain circumstances, as follows: $0.1 million in 2004; $0.4 million in each of 2005 and 2006; $2.1 million in each of 2007, 2008, 2009; and $3.2 million in 2010. The agreement also provides the Owners the right to require us to purchase those ownership interests at the above-described times and op tion prices. These put rights can be exercised for any options that have come due but which were not exercised by us up to that point in time, but no later than December 31, 2010.

     The following table provides information about our contractual obligations and commitments in future years as of December 31, 2004 (in thousands):

     We are exposed to market risk because we hold debt that is sensitive to changes in interest rates. We manage our interest rate risk exposure by maintaining a mix of fixed and variable rates for debt. The following table provides information regarding our market sensitive financial instruments and constitutes a forward-looking statement.

     The fair value of our long-term debt increased as of December 31, 2004 compared to December 31, 2003 as a result of the consolidation of Clipper. (See "Note 10 - Variable Interest Entities.")

     Information with respect to Item 8 is contained in our consolidated financial statements and financial statement schedules and are set forth herein beginning on Page F-1.

  None.

     As of the end of the period covered by this report, our management, including our principal executive officer (Richard Matros) and principal financial and accounting officer (Jennifer Botter), conducted an evaluation of the effectiveness of our disclosure controls and procedures. Disclosure controls and procedures are designed to ensure that information required to be disclosed in our periodic reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Based on that evaluation, our principal executive officer and principal financial and accounting officer concluded that our disclosure controls and procedures are effective. No change in our internal control over financial reporting occurred during the last fiscal quarter of 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

     Management is responsible for establishing and maintaining adequate internal control over financial

41

reporting. We maintain a system of internal control that is designed to provide reasonable assurance as to the fair and reliable preparation and presentation of the consolidated financial statements, as well as to safeguard assets from unauthorized use or disposition. 

    We conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2004 based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). This evaluation included reviewing the documentation of controls, evaluating the design effectiveness of controls, testing the operating effectiveness of controls and making a conclusion on this evaluation. Although there are inherent limitations in the effectiveness of any system of internal control over financial reporting, based on our evaluation, we have concluded that our internal control over financial reporting was effective as of December 31, 2004.

     Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their attestation report, which is included herein. (See page F-3.)

None.

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     Our directors and executive officers as of March 1, 2005 were:

     Richard K. Matros, age 51, has been our Chairman of the Board and Chief Executive Officer since November 2001. Mr. Matros served as Chief Executive Officer and President of Bright Now! Dental from 1998 to 2000. He served Regency Health Services, Inc., a publicly held long-term care operator, as Chief Executive Officer from 1995 to 1997, as President and a director from 1994 to 1997, and as Chief Operating Officer from 1994 to 1995. He served Care Enterprises, Inc. as Chief Executive Officer during 1994, as President, Chief Operating Officer and a director from 1991 to 1994, and as Executive Vice President - Operations from 1988 to 1991. Mr. Matros currently serves on the board of directors of Bright Now! Dental and Meridian Neurocare, LLC.

     L. Bryan Shaul, age 60, has been our Executive Vice President and the Chief Financial Officer since February 2005. From 2001 to February 2005, Mr. Shaul was the Executive Vice President and Chief Financial Officer of Res-Care, Inc., a publicly owned provider of services to persons with developmental disabilities and special needs. From 1999 to 2001, he served at Humana Inc., a health insurance company, most recently as Vice President-Finance and Controller and prior to that as Vice President of Mergers and Acquisitions. From 1997 to 1999, Mr. Shaul was Chief Financial Officer of Primary Health, Inc., a physician practice management and HMO company. From 1994 to 1996, he was the Senior Vice President and Chief Financial Officer of RightCHOICE Managed Care, Inc. From 1971 to 1993 he held various positions with Coopers & Lybrand, most recently as the Partner-In-Charge of Insurance Practice.

     Steven A. Roseman, age 46, has been our Executive Vice President, General Counsel and Secretary since May 2002. From March 2001 to May 2002, Mr. Roseman was Counsel to the law firm of LeBoeuf Lamb Greene & MacRae, LLP. From 1997 to 2000, he was Senior Vice President, General Counsel and Secretary of American Health Properties, Inc., a NYSE-listed healthcare-oriented real estate investment trust. Previously, Mr. Roseman was Vice President Business Affairs Worldwide Pay Television for

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Paramount Pictures Corporation and, prior to that, was a partner in Ervin, Cohen & Jessup, a Beverly Hills, California law firm.

     Chauncey J. Hunker, Ph.D., age 54, has been our Corporate Compliance Officer since 2000. From 1996 to 2000, Dr. Hunker served as Vice President of Continuous Quality Improvement of SunDance Rehabilitation Corporation, our rehabilitation therapy subsidiary ("SunDance"). From 1995 to 1996, he was a Clinical Director of SunDance, and from 1992 to 1995 he was Regional Vice President of Learning Services - Midwestern Regional Facility in Madison, Wisconsin. Dr. Hunker has also served as Adjunct Assistant Professor, Department of Neurology, at the University of Wisconsin Medical School since 1989.

     Heidi J. Fisher, age 48, has been our Senior Vice President of Human Resources since February 2002. From 1998 to 2002, Ms. Fisher was Vice President Human Resources of Bright Now! Dental, a dental practice management company. From 1997 to 1998, she was Corporate Director of Human Resources at Covenant Care, Inc., a long-term care company. From 1994 to 1997, Ms. Fisher was with Regency Health Services, Inc., a long-term care company, most recently with the title Senior Director of Human Resources. From 1987 to 1994, Ms. Fisher was Senior Manager of Human Resources with Volt Delta Resources, Inc.

     Jennifer L. Botter, age 42, has been our Senior Vice President since February 2004 and our Corporate Controller since 2000. From 1998 to 1999, Ms. Botter held various positions with us. From 1996 to 1998, she was Director of Finance for Fulcrum Direct, Inc., a manufacturer and cataloguer of children's apparel. From 1984 to 1996 she held financial consulting and accounting positions in the high technology and manufacturing industries. Ms. Botter has served as our principal accounting officer since 2001 and as our principal financial officer since December 2004.

     William A. Mathies, age 45, has been President of SunBridge Healthcare Corporation, our inpatient services subsidiary, since March 2002. From 1995 to March 2002, Mr. Mathies served as Executive Vice President of Beverly Enterprises, Inc., a long-term care company. Most recently, he was the Executive Vice President of Innovation/Services for Beverly. He previously served Beverly as President of Beverly Health and Rehabilitation Services, (the long term care subsidiary of Beverly), from 1995 to 2000, and various other operational positions from 1981 to 1995.

     Tracy A. Gregg, age 51, has been President of SunDance Rehabilitation Corporation, our rehabilitation therapy services subsidiary, since 2000. From 1987 to 1999, Ms. Gregg was employed by NovaCare, Inc in various capacities, most recently as Senior Vice President of Operations of the Long Term Care Division. Ms. Gregg has over 30 years of experience in the long-term care industry. From 2000 to present, Ms. Gregg served on the NASL Board of Governors and from 2002 to present, she was the Chair of the NASL Medical Services Committee and a subcommittee member of AHCA's Clinical Practice.

     Richard L. Peranton, age 55, has been President of CareerStaff Unlimited, Inc., our medical staffing subsidiary, since November 2004. From 2001 to November 2004, Mr. Peranton was the President and Chief Executive Officer of EMSI, Inc., a leading medical information services provider related to risk management services. From 1994 to 2001, he was the President and Chief Executive Officer of Nursefinders, Inc., one of the nation's largest providers of temporary staffing services. From 1981 to 1994, he served in various capacities, most recently as President - Southern Division, with Olsten Kimberly Quality Care, a provider of supplement health care staffing.

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     Jennifer L. Clarke, age 50, has been President of SunPlus Home Health Services, Inc., our home healthcare services subsidiary, since 1997 and of SunAlliance Healthcare Services, Inc., our mobile radiology and laboratory services subsidiary, since 1999. From 1995 to 1997, Ms. Clarke was Vice-President of the Southern California region home health services for Regency Health Services, Inc. and from 1990 to 1995 she served as Vice-President of Operations for LifeCare Solutions, a multi-site California based home health and home infusion company. From 1983 to 1990, she was the administrator of a hospital-based home health agency, West HealthCare. Ms. Clarke was an executive officer of SunAlliance and SunPlus when they commenced chapter 11 bankruptcy proceedings in October 1999.

     Mary K. Ousley, age 59, has been Executive Vice President of SunBridge Healthcare Corporation since 2001. From 1999 to 2001, Ms. Ousley was Senior Vice President Health Service for Marriott International's Senior Living Division. From 1996 to 1999, Ms. Ousley was employed by Horizon Healthcare Corporation, which was acquired in 1997 by Integrated Health Services, Inc., as Vice President Clinical Services for Horizon and as Senior Vice President Government Affairs for Integrated Health Services. From 1991 to 1996, Ms. Ousley was Corporate Director Professional Services for the Hillhaven Corporation and from 1980 to 1991 she was Executive Administrator for EPI Healthcare Corporation. Ms. Ousley served as President of the American Health Care Association, the largest trade organization representing long-term care from 2001 to 2003. Over the past fifteen years, Ms. Ousley has been appointed to, and has made recommendations for, the General Accounting Office (G AO) and the Joint Commission on Accreditation of Healthcare Organizations (JCAHO), and has served in various capacities as an advisor to the Centers for Medicare and Medicaid (CMS). She is currently serving on the CMS and Quality Improvement Organization's technical expert panel on the development and implementation of a quality improvement model for long-term care.

     Gregory S. Anderson, age 48, has served as a member of our Board of Directors since November 2001. Mr. Anderson has served as the Chairman, President and Chief Executive Officer of Valley Commerce Bank Corporation and Valley Commerce Bank since 2004. He served as President and Chief Executive Officer of Glendora Holdings, LLC, an operator of long-term care facilities and medical imaging centers, from 2002 to 2004. He served as President and Chief Executive Officer of Quality Care Solutions, Inc., a publicly held provider of software and services for the healthcare industry, from 1998 to 2002. Prior to 1998 Mr. Anderson was in the venture capital business. From 1993 to 1998 he was President of Anderson & Wells Co., the venture capital manager of Sundance Venture Partners and El Dorado Investment Co. Mr. Anderson currently serves on the board of directors of Hawaiian Airlines, Inc., a publicly held airline (which commenced bankruptcy proceedings in March 2003) and Valley Commerce Bank.

     Christian K. Bement, age 62, has served as the President and Chief Executive Officer of Earl Scheib, Inc., a publicly held chain of auto paint shops, since 1999.  From 1995 to 1998, he served as Executive Vice President and Chief Operating Officer of Earl Scheib, Inc.  He previously served on the board of directors and as an officer of Thrifty Corporation, an operator of drug stores and sporting goods stores, as Executive Vice President from 1990 to 1994 and as Senior Vice President of Industrial Relations from 1985 to 1990.  Mr. Bement has served on the board of directors of Earl Scheib, Inc. since 1997, and is

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one of the founders and has served on the board of directors of the 1^st Century Bank located in Century City, California since 2004.

     Steven M Looney, age 55, has served as the Chief Financial Officer of Pinkerton Computer Consultants Inc., an information technology firm, since 2000 and as a Director of WH Industries Inc., a precision metal parts manufacturing company, since 1992 and as Chief Financial Officer of that firm from 1992 through 1999. From 1990 to 1997, he served as a director of Computers at Work Ltd, a hand-held computer consulting firm. From 1987 to 1992, he served as Managing Director of Peale Davies and Co. Inc., a mergers and acquisitions and strategic advisory boutique. Mr. Looney is a Director Nominee for Tranmit, PLC.

     Milton J. Walters, age 62, has served as a member of our Board of Directors since November 2001. Mr. Walters has served with investment banking companies for over 30 years, including: Tri-River Capital since 1999 and from 1988 to 1997, as President; Prudential Securities from 1997 to 1999, most recently as Managing Director; Smith Barney from 1984 to 1988, most recently as Senior Vice President and Managing Director; Warburg Paribas Becker from 1965 to 1984, most recently as Managing Director. He currently serves on the Board of Directors of Decision One Corporation, Fredericks of Hollywood and Quest Products Corporation.

     The Board of Directors of Sun Healthcare Group, Inc. has established an Audit Committee to oversee our accounting and financial reporting processes on behalf of the Board. The Audit Committee currently consists of five members of the Board of Directors, all of whom are "independent" as defined by Nasdaq: Milton J. Walters (chair), Gregory S. Anderson, Tony M. Astorga, Christian K. Bement and Steven Looney. The board has designated one member of the Audit Committee, Mr. Walters, as a financial expert, as defined by the Securities and Exchange Commission. Mr. Walters' biography is set forth above.

     Section 16(a) of the Exchange Act and the rules promulgated thereunder require our directors and executive officers and persons who own more than ten percent of our common stock to report their ownership and changes in their ownership of common stock to the Commission. Copies of the reports must also be furnished to us. Specific due dates for the reports have been established by the Commission and we are required to report any failure of our directors, executive officers and more than ten percent stockholders to file by these dates.

     Based solely on a review of the copies of such forms received by us, or written representations from certain reporting persons, we believe that during 2004 all Section 16(a) filing requirements applicable to our directors, executive officers and greater than ten percent beneficial owners were met, except as follows: (i) each of Ms. Gregg, Mr. Anderson and Mr. Walters and Sanjay Patel and Dr. Vladeck (former directors) filed one late Form 4, and (ii) each of Mr. Astorga, Mr. Bement, Mr. Looney and Mr. Peranton filed a late Form 3 and one late Form 4. Each late Form 4 reported one transaction consisting of the granting of awards under the Corporation's 2004 Equity Incentive Plan.

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     We adopted a Code of Ethics that applies to Mr. Matros as our Chief Executive Officer, Mr. Shaul as our Chief Financial Officer, Ms. Botter as our Corporate Controller, and other financial personnel. The Code of Ethics is designed to deter wrongdoing and to promote, among other things, (i) honest and ethical conduct, (ii) full, fair, accurate, timely and understandable disclosures, and (iii) compliance with applicable governmental laws, rules and regulations. The code of ethics is attached as an exhibit (see Item 15 - Exhibits) and is also available on our website www.sunh.com. If we make any substantive amendments to the Code of Ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer or Corporate Controller, we will disclose the nature of such amendment or waiver on our website.

     The following table provides information concerning employment compensation for services to us and our subsidiaries for the fiscal years shown for those persons (the "Named Executive Officers") who were, during the year ended December 31, 2004, (i) the individuals who served as chief executive officer, and (ii) the other four most highly compensated executive officers.

     The following table sets forth certain information concerning individual grants of stock options made to each of the Named Executive Officers during the year ended December 31, 2004:

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